Monday, November 26, 2012

The Fiscal Cliff

Ben Bernanke's ominous metaphor of a fiscal cliff to describe the pending economic contraction brought on by expiring tax cuts and mandated spending cuts has now embedded itself in the lexicon. We've heard the beltway buzz surrounding the fiscal cliff described as "cliff diving", we've heard the cliff characterized as "more of a fiscal slope" and by one Citigroup equity strategist even as a "bungee jump". Leave it to the ingenuity of Americans to turn a phrase.

The concern, however, is that many Americans are confusing the issues that may impact the economy in the very near term, with prudent fiscal policy in the longer term. The markets, for their part, are largely discounting the whole affair, believing that at the 11th hour the politicians will "compromise" and, therefore, avoid the cliff.

But let's take stock as to what is on the table and what it means to compromise. At year end, absent any political tinkering, roughly $600 billion of fiscal tightening is scheduled to trigger in the federal budget. Approximately $100 billion of this total will come from sequestration of expenditures and the balance from the expiration of the Bush era tax cuts, the payroll tax, estate, AMT and capital gains taxes. In a word: austerity. This is the do-nothing scenario, the dreaded fiscal cliff.

With politicians being as they are, however, the do-nothing scenario is largely discredited to the muddle-along. Each party has drawn lines in the sand, and then another and another. The question is what does it really mean to compromise. The "grand bargain" as it's been discussed (there's that turning of the phrase, again) would involve the Republicans conceding to tax increases on the wealthy and Democrats agreeing to some level of spending cuts. Should this come about, both measures will place fiscal drag on the economy, just less than the do-nothing scenario, rendering the cliff into something more of a fiscal slope.

And this is precisely our dilemma. We all recognize that the government cannot go on endlessly racking up $1 trillion plus annual deficits, yet any measures to narrow the deficit or impose austerity, contribute to the cliff. In the do-nothing scenario, the annual budget deficit would be cut in half in one year, but the fiscal drag on the economy would amount to as much as 4% of GDP. This takes us then to the very nub of the problem: with the current level of federal deficit spending amounting to 8% of GDP any effort to rein in the deficit, poses a significant drag on the economy. In essence, our economy is on life support and we are between a rock and a hard place.

Now, what's most curious about this is the Obama position. Immediately following the election he came out swinging: any proposals to resolve the fiscal cliff must involve higher taxes on the wealthy. Ok, we get it. He's Robin Hood and we're all living in the Sherwood Forest. While this approach might hold populist appeal, it's curious in terms of its economic impact.

The CBO estimates that allowing the Bush era tax cuts to expire on the wealthy would raise approximately $42 billion per year - or roughly 4% of the budget deficit. Four percent. So, Obama is willing to endure $42 billion of fiscal drag because he's now preoccupied with fiscal prudence? And if it's an insignificant level of drag, at 4% of the deficit isn't it also an insignificant amount of budget savings?

It hardly sounds reasonable. Rather, it seems Obama is searching for a grand political statement cloaked as a grand bargain. He is saying that America is unfair. Income disparity is unfair. The tax system is unfair. The rich are unfair. Capitalism is unfair. It's all just so stinking unfair. And we have to do something about it. Little, but something. Perhaps insignificant in the scheme of things, with little hope of tackling America's real economic issues, but something.